Although “revenue recognition” sounds like an arcane topic (and it is), selling business owners should beware, as the timing of costs and revenues repeatedly causes troubles for middle market transactions. Because of the complexity of the accounting rules around this topic, many deals struggle to get through economic due diligence due to sellers’ lack of understanding of this issue. The result is often that after an external review, buyer’s accountants appropriately (but unexpectedly to the seller) restate the earnings of a selling company, significantly changing the valuation of the company.
In essence, an appropriate revenue recognition policy matches up the costs and revenue associated with services or projects that take a long time to complete. While not particularly important to companies with discrete transactions, sellers with significant revenue associated with long term projects or services need to be particularly aware of the appropriate standards.
As an example, in the IT services space, a single contract may include the purchase of equipment, engineering services, and long term services. The contract may include payments with a variety of timing, including at contract signing, throughout the work, at completion, and also over the course of the maintenance period. On the cost side, equipment could be purchased up front, while labor costs are recorded over time. It is important to make sure that these payments and costs are matched up, and also matched up with the contract for the work. If these payments and costs spread out over multiple accounting periods, the issue can become even more magnified.
While buyers understand that many middle market companies don’t maintain their books to Generally Accepted Accounting Principles (GAAP), the issue of revenue recognition is one that a selling company needs to have its arms around to successfully take a company through the sale process.
This isn’t easy! The Financial Accounting Standards Board (FASB) reports that currently, there are over 200 specialized and/or industry-specific revenue requirements under GAAP. FASB currently has a project to simplify these standards.
Unfortunately, despite the complexity of revenue recognition, this is an issue I’ve personally seen destroy transactions.
Make sure you’ve worked this issue through with your team well before you start the sale process.Share: